- The U.S. and Europe are overvalued, especially seeing the current political situation and economic fragility.
- What’s about to hit Europe and the U.S. already hit emerging markets in 2015. There are opportunities in emerging markets now, but where?
- Bonds seem the riskiest asset of all with no yield and huge potential downside.
After last week’s BREXIT vote the markets have been in a free fall with a slight recovery yesterday. But savvy investors have been expecting this and it has been a recurring theme at Investiv Daily that stocks are overvalued. In such an overvalued environment it is normal that inflated asset prices take a beating at any sign of future uncertainty.
As one’s misfortune is another’s fortune, this article is going to elaborate on what to look for and what to avoid in order to limit risks and maximize returns.
The U.S. Stock Market
The U.S. stock market is fully valued and therefore the decline should not have come as a surprise. The S&P 500 has been moving sideways for the last year and a half and many are expecting a recession. In such an environment the risks are high and the potential returns very low.
Figure 1: S&P 500 PE ratio and earnings. Source: Multpl.
With a PE ratio of 24 and declining earnings, the only way for investors to realize capital gains by investing in the S&P 500 would be through the formation of an asset bubble. With the current political turmoil, slower U.S. productivity, lower employment participation and strong dollar, this seems like a very unlikely scenario.
On the other hand, those factors might start a recession that could easily lower the S&P 500 to the average historical PE ratio of 15 which would cause a 1,300 point, or 35% drop. Therefore, the conclusion is that the S&P 500 carries a lot of risks with limited upside.
Emerging markets were the thing to avoid in 2015, but they still possess long term factors that should make them the long term investment winners, especially if bought at these depressed prices. Let us focus on Brazil as an example.
Brazil was hit by various corruption scandals and by the deepest recession in the last two decades. But, Brazil is still a young country rich in natural resources and on the road to becoming part of the developed world, minor setbacks are normal and should be used as an investment opportunity.
Figure 2: Brazil’s GDP in billions of US dollars. Source: Trading Economics.
Brazil’s GDP grew from $1,107 billion to $2,346 billion in ten years which still represents a yearly average growth of 7.7%. As the market has already factored in the chance of a Brazil bankruptcy, the risks and rewards of investing there are opposite from what they are in the U.S., as there is no risk of a U.S. bankruptcy.
Brazil’s current CAPE (Cyclically adjusted 10 year average price earnings ratio) is currently 3 times undervalued at 8.2, while the S&P 500 has a CAPE ratio of 24.6. The undervaluation is probably the reason why Brazilian stocks have behaved very well in the last few days. The Brazilian stock index is still in positive territory for the month and year to date. On top of the relative stability, U.S. investors could also gain from currency benefits as the oversold real is slowly returning to its real exchange value toward the dollar.
Figure 3: USD vs BRL in the last year. Source: XE.
To conclude, Brazil represents a young, resource rich country where it seems that all that could go wrong did go wrong last year. More positive news than negative news should now be expected. On top of that, it is one of the most undervalued markets in the world.
The situation in Europe is similar if not worse than the one in the U.S. To put it simply, the markets are in an asset bubble as the European Central Bank has been issuing huge amounts of liquidity with the hope of faster economic growth and some inflation. It succeeded for a while but the BREXIT issue will for sure have a negative impact on current economic growth when coupled with the overvalued markets, the risks outweigh the rewards.
The average PE ratio in Italy is 31.5, Netherlands 28.5, United Kingdom 35.4 and Germany 19. There is also the euro issue where any political turmoil could weaken the euro and lower investment returns for U.S. investors.
Europe should be avoided until asset prices reflect the real state of the economy and the political situation, thus far below current prices, at least 50%.
Gold and Bonds
It is uncommon to put gold and bonds in the same basket but as they both have practically no yield with negative interest rates on the most secure government bonds, it seems the right choice.
Gold is currently at its year high as investors look for safety. The problem with gold is that it has no yield and most investors come too late to the party as gold primarily appreciates at maximum turmoil as it has done in the past few days.
Figure 4: Gold prices in the last year. Source: Bloomberg.
If political turmoil persists and inflation arrives due to the high liquidity, gold might be the winner, but any signs of stabilization would negatively affect gold. It can be concluded that gold represents a good hedge and could be a part of a well-diversified portfolio. Investors that seek a riskier investment than gold itself could go for gold mining stocks that offer a dividend yield and potential growth, though gold mining stocks also come with much more volatility.
As for government bonds, the risks seem to outweigh the rewards. Yes, it is possible to make capital gains if interest rates further decline, but this defies logic as there is no point in holding negative yielding bonds. On the other hand, if yields increase bonds could fall tremendously as a 100% increase in bond yields should consequently lower bond prices by 50%. Therefore, the current situation with bonds isn’t what’s typically assumed about bonds—low risk with high rewards—as right now they are high risk with low rewards.
At this point, after a 7-year bull market and high liquidity provided by central banks, investors should be wary of being overweight in the same things that were good 7 years ago. Many analysts have forgotten how to analyze risk as we have not seen a bear market since 2009, but this is exactly the time when one should look at risks before rewards. High asset prices and low yields mean that investors do not see much risk and are willing to pay hefty prices, but this is exactly the kind of situation that can bring lots of investment pains.
Any signs of recession, the continuation of the decline in corporate earnings, and a shift from the current investor’s perception that central banks are still able to save the markets with additional intervention, could easily send the stock market down by 30%. Assess your risks, estimate the rewards, and position your portfolio accordingly.